America’s Mark-to-Model Banking System (revisited)

Posted on November 20th, 2008 in Daily Mortgage/Housing News - The Real Story, Mr Mortgage's Personal Opinions/Research

Reflection time – earlier in the year I put together a chart for my own personal use showing all financial institutions Level 1, 2 and 3 assets vs their shareholder equity, tier capital etc. After not too long I realized it was a fairly good guide to troubled financial institutions.

I posted it on the blog on Oct for all of you guys and got emails about it for a month. I think its time to review the chart because it clearly shows why all this is happening and why TARP could not be used to buy distressed assets.

Everyone was focused on Level 3 and glossed right over Level 2, which could be equally as toxic and marked to some sort of internal proprietary modeling system that give these assets much more value than reality. For many of these firms at the top of the list a mere 5% haircut in their Level 2 book renders them insolvent. This is where a lot of that nasty commercial resides.

Citi said today that its balance sheet is not that much different that Chase – by the looks of Chase’s Level 2 assets to equity, they better hope not.

Remember, its not a liquidity problem, its a solvency problem, which this chart clearly shows. The institutions listed here were my top 25 short picks earlier in the year based upon this chart. Some still look good. Please note that I have not updated this chart completely because I have not had the time but since I have not heard of very many banks selling massive amount of bulk assets, I would assume that these numbers have not shrank, more likely grown. -Best Mr Mortgage

America’s Mark-to-Model Banking System

Oct 2nd 2008

Is $700bb really enough?  Buying distressed assets from banks balance sheets is a waste of money. How insolvent are the nation’s leading banks?

Level 1, 2, and 3 assets are ways of classifying a company’s assets based on the degree of certainty around the assets’ underlying value. For example, Level 1 assets can be valued with certainty because they are liquid and have clear market prices. At the other end of the spectrum, Level 3 assets are illiquid and estimating their value requires inputs that are unobservable and reflect management assumptions. Think of it like Prime, Alt-A and subprime mortgage loans for example.

Somehow we have skipped right over Level 2 and are judging bank risk by looking at Level 3. Maybe in a robust credit market full of securitizations and leverage like 2006 this would have been just fine, but not now.  Perhaps this is unfolding in a linear way just like the mortgage crisis beginning with subprime (level 3), now onto Alt-A (level 2), then to Prime (Level 1).  Walls Street did a similar thing last year when it went right to focusing on CDO’s and forgot about all of the toxic whole loans and MBS on the balance sheet.

In the past several months, banks have been very focused on ‘selling assets and bringing down leverage’ with the primary focus being on their mostly toxic Level 3 ‘assets’.  That would be fine and dandy if their Level 2 ‘assets, which in this market may be equally as hard to value as Level 3, were not up to 20 times greater in Bank of America’s case for example.

The chart below show total Level 1, 2 and 3 ‘assets’. I have been keeping this for many quarters but shown is only Q2. However, if you look at level 2 assets/equity percentages it has been a road map to troubled banks with the exception of a few…but are those really exceptions.

**PLEASE NOTE – Chart below may not reflect accurate shareholder equity – needless to say it is much lower now.

**Note: This chart is a couple of months old numbers may have changed. My Excel is a little rough sometimes at times as well so you can visually look at row amounts vs total assets/equity in order to run your own ratios.

Level 2 ‘assets’ are by definition “Assets that aren’t actively traded, but have quoted market prices for similar instruments – otherwise known as ‘mark to model.'”  Could this be more mortgage debt?  We all know that all ‘modeling’ systems are broken and have been for years so how accurate are these marks, especially if much of this is mortgage debt. Look at the Wachovia line above. They have $160 billion in Level 2 assets.  That number is eerily similar to the amount of toxic Pay Option ARMs they hold.

The Level 2 numbers are so staggering that even a 7.5% haircut across the small group banks below would equal the total write downs by all banks worldwide to date!

Back on May 2nd I posted a story on Merrill playing ‘hide the CDO’ for reference and have updated my chart on 25 of the top financials and their Level 1, 2 and 3 exposure. What I found was astoundinig.  Of the 25 companies I studied, their total assets were $14.6 Trillion, Level 1 assets were a total of $1.3 Trillion, Level 3 assets were only $802 Billion but Level 2 Assets were $7.3 TRILLION!

Are you kidding me! 50% of the group’s total assets were Level 2 “assets that aren’t actively traded, but have quoted market prices for similar instruments – otherwise known as ‘mark to model.”

Wouldn’t it be great if the banks let you mark your investment portfolio to what you believed the assets to be worth on those dreaded days on which you receive a margin call?

All joking aside, this is an absolute disaster in the making. The Treasury does not have enough to take care of many of the nation’s largest banks.  The Fed does not either. As you can see they are OVER their heads in Level 2 and Level 3 ‘assets’, of which much has not been able to be priced for months. Much of it never will. -Best, Mr Mortgage

  • Level I: Mark to Market – readily observable market prices.
  • Level II: Assets that aren’t actively traded, but have quoted market prices for similar instruments – otherwise known as ‘mark to model.’
  • Level III: Assets that have model derived valuations in which one or more significant inputs or significant value drivers are unobservable-otherwise known as ‘mark to myth’ or ‘mark to management’s best guess,’ ‘mark to a hope & a prayer,’ etc…
  • More Mr Mortgage

    11 Responses to “America’s Mark-to-Model Banking System (revisited)”

    1. Clarification request: using Wachovia and their level 2. The $150B of Level 2 assets are disclosed by Wachovia as *their calculation of value of those assets*? My understanding of Wachovia’s reporting of Option ARMS was they would report the value of a fully-paid Option ARM. So if the COSI + 3% = 8%, but minimum payment (that all their customers actually make) is 2%, they would report value of the 8% loan. Overstating what they were actually receiving and justifying it because the delta is added to the loan incumbency. Is THAT the $150B they are reporting?

    2. Mr. Mortgage,

      Spread that chart around and invest in the producers of antacids and insomnia remedies.


    3. Mr. Mortgage,

      You aptly mention that the L2/L3 assets probably haven’t fallen much and may have even grown. However, there’s something just as important and in plain view that you don’t mention: their equity has plummeted!

      Just real quick, the chart still has Citi at $136B of equity, when it is more like $24B now! Ambac is at $1.9B of equity, when it is more like $330M!

      So the ratios are almost certainly way way worse now!

    4. Note that BofA’s equity has plummeted from $162B to around $50B. And that now INCLUDES Merrill (as well as Countrywide). Hmm…

      Also note that Wells has done capital raises and is on that basis in a stronger position. However, I suspect they don’t mark any of their “held to maturity” portfolio to L2 or L3 (can anyone confirm?) We know Wells has probably enough second-lien loans and commercial/construction loans that, if classified as tradable, there would be a serious valuation hit.

    5. So how does one survive (maybe even thrive) the 2008 Meltdown?

      Short the XLF, specific banks? If I’m reading the tealeaves quasi-correctly, A high percentage of people will be upside down on their home? Their mutual funds will take a 50% haircut, and they or someone they know will loose their job.

      What is the winning strategy?

    6. Invest in the vice fund (ticker VICE). It is comprised solely of alcohol, tobacco and guns. Rock solid investment as people enjoy these things when times are good and when times are tough. Check it out.

    7. yes, this was one of the most compelling Mr. Mortgage posts ever

    8. Great spreadsheet about Level 1, 2, and 3 assets for the major banks! Please update and re-publish quarterly as this mess is far from over and people need to be reminded of the problem frequently. For a good record, keep the data for all banks even when they have gone bankrupt or been bought out; perhaps add a “Bank Status” column. Also, add totals for all columns in the spreadsheet. Keep up the good work!

    9. Loren Said:

      “So how does one survive (maybe even thrive) the 2008 Meltdown?”

      Find a company that makes razor wire or one that does board ups.

    10. […] More… […]

    11. […] the article entitled “America’s Mark-to-Model Banking System (revisited)” (Read here). He points out that everybody is focused on Level-3 assets, which are the obscure asset backed […]

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